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High oil prices and the end of globalization really?
Or a missed opportunity for Mexico and Venezuela

By Roger Tissot

Oil prices almost broke the benchmark of $70/b to fall back to $66.12, according to the Yahoo note I read on my computer today. Apparently there is more oil in storage than expected. But, as the note continues to say, prices may stay around the $66 because fear of inflation and a weakening dollar may result in higher prices despite the economic recession.

It is a particularly thankless job to be an oil forecaster, as there are numerous unknowns: from the demand side, China has a very large impact but the accuracy of their information is anybody's guess. From countries with better access to information, such as the United States , there is also large room for error, as most economists can testify from their failure to predict the severity of the current economic recession. From the supply side, accessing the right information is already a challenge. For example, one would expect that OPEC, created by the largest oil producing countries for the sole purpose of defending producers' interests (i.e. prices), would have the best information available on their own members' production. That does not seem to be the case as the Government of Venezuela is trying to convince everybody that Venezuelan production is higher than what OPEC has reported. Of course, the biggest unknown is oil reserves. These are even more difficult to forecast since politicians and company executives have a vested interest in inflating them.

The world of oil can be divided into two basic camps: the oil pessimists who adhere to the peak oil theory, and the oil optimists who think that given the right economic incentives, human ingenuity and technology, we would be able to find more of the "black gold".

Jeff Rubin, a Canadian economist "guru" and for 20 years the chief economist of the Canadian Imperial Bank of Commerce, has written a fascinating book about what the world may look like in the era of peak oil and three digit oil prices ( Why Your World is About to Get a Whole Lot Smaller: Oil and the End of Globalization, by Jeff Rubin, Random House Canada ) Rumors are that the book cost Mr. Rubin his job at the bank. I do not know, but I am not surprised to see the bank unhappy with their chief economist moving from forecasting interest rates or GDP growth to futurology.

Rubin's premise follows that of Dr. Colin Campbell, by whom you can find extensive reading and analysis at the Association of the Study of Peak Oil, http://www.peakoil.net/ , which suggests that "global oil production will soon be in the backside of the Hubbert curve...daily production would soon peak, plateau and then begin its irreversible decline"[1]. The Hubbert curve is the bell shaped curve the famous American Geologist King Hubbert referred to when describing the life of an oil reservoir.

Rubin puts oil at the center of the economy, and according to him it is thanks to cheap oil that modern globalization was possible. His compelling example, at the beginning of his book, is the story of a salmon caught in the Northern Atlantic sent to a port in Norway to be frozen and shipped to Rotterdam where it is then shipped to China to be processed then frozen again and repackaged to be shipped to a market in North America and put on display as "fresh fish". All the drivers of globalization, including some of the modern strategies of management such as just in time inventories and outsourcing have been possible because of cheap oil.

If the price of oil increases, this model falls apart. And that is what, according to Rubin, we saw happening last year when gasoline reached US$4/gallon. Americans stopped using cars and started to re-discover the benefits of public transportation, albeit a highly deficient one which was unable to cope with the surge in demand. Rubin does not blame the economic recession only on the sub-prime Ponzy scheme of some smart Wall-Street mavericks, but on high oil prices, which eroded consumer disposable income and demand.

He thinks the previous crisis, which brought us high oil prices (but lower than last year prices as seen in the following graph) resulted in a good news/bad news situation known as "the efficiency paradox". Net improvement in energy efficiency actually increased energy consumption instead of causing an overall decline in the demand for energy. American cars today are more energy efficient than 20 years ago, but they are heavier and full of electronics. We have, as a society, opted to improve our standard of living (McMansions, two or three cars per family, suburban residences, frequent flyer programs) as we became more energy efficient, instead of learning to conserve energy.

In addition, all the improvements in energy efficiency were not a match for the surge in demand from emerging economies such as China and India and their new love affair with automobiles. According to the recently published energy outlook (2009-2030) from the US Department of Energy http://www.eia.doe.gov/oiaf/ieo/index.html , non OECD demand for energy will grow by 73% while OECD demand will grow by only 15%.

Oil discoveries of course continue to occur, but as Rubin points out, these are smaller and much more expensive to bring to market. For example, Ghawar, the largest oil field in the world, discovered in Saudi Arabia in 1948, once held 60 billion barrels. Tupi, the source of so much pride in Brazil , is a "modest" 8 billion barrels, plus it is below 2,000 feet of water, 10,000 feet of rock and 6,000 feet of salt. Tupi will be expensive oil, similar to the Canadian Tar Sands, another huge source of oil located in northern Alberta . According to a recent study by the Canadian Energy Research Institute (CERI) an integrated mining and upgrading tar sand project producing approximately 100,000 b/d will need an oil price of $100 WTI to be profitable. Of course these values do not include potential extra costs from a cap and trade legislation that could increase the priceof carbon. The Orinoco belt in Venezuela is also expensive, albeit cheaper than the Canadian crude. In short, the new sources of oil are located in difficult to reach, environmentally sensitive and politically difficult areas.

Oil producing countries, particularly but not exclusively, members of OPEC, have also contributed to the potential scarcity of oil by cannibalizing their own source of wealth. In fact, demand for oil skyrocketed in oil producing countries due to their economic boom and huge price subsidies that protected locals from international price signals. Venezuela is perhaps the most dramatic case. The surge in domestic demand translated into less oil available for exports, or worse, the import of very expensive gasoline, diesel and jet fuel since in many cases local refineries were unable to meet demand.

Rubin's book does not try to convince you of the merits of the peak oil theory but describes a picture of a world where oil prices are very high. In that world, trade will severely suffer since transportation costs will erode the competitiveness of low labour costs. Companies that moved their factories to China or other low labour cost countries would be penalized. With an oil price of $100, importers pay 150% more to ship from China , eroding all the gains of lower tariffs from trade negotiations. In a high oil price environment, Rubin thinks unions and environmentalists will have a "common cause": to fight for low carbon emissions and for bringing jobs back to America .

I personally think the book is an interesting read, but perhaps provides a taste of nostalgia for an era I doubt will return: An America with a large blue collar middle class, with cities and towns relying on locally produced good and services. In short a much less globalized world.

First, if manufacturers are forced to go back where the market is, one can be assured that cheap labor will follow - even if many walls are built between US and Mexico . Second, most Americans are training to work in the service sector, and though a union job at a factory may look attractive compared to a fast-food restaurant job, those factories will adjust their wages lower as the supply of domestic and foreign labor increases. There is always the possibility of moving the factories to Mexico , which even at high oil prices, is still closer to America than China .

But to me the most important point of the analysis is the risk of huge loss of economic welfare because of lower trade. In 2009, trade is declining by approximately 9%, a symptom of how deep the current recession is. I doubt humanity will sit idly by and accept a lower standard of living just because we cannot move goods and services as efficiently as we once did. Perhaps we may temporarily enter a smaller world, but a combination of economic policies (lifting oil price subsidies, taxing carbon emissions), investments in public transportation, and energy efficiency should allow humanity to continue to enjoy the benefits of trade and globalization.

The book however made me think about the huge opportunity countries such as Venezuela and Mexico have and are wasting, because of their resource nationalism. In fact, the EIA predicts oil prices will increase from $61/b (2007 prices) to $130/b (2007 price) by 2030. Rather than claiming the current economic crisis is the collapse of capitalism (which is not), Venezuela should focus on expanding its production capacity by increasing investments. Venezuela could capture a significant revenue as prices move upward but it requires to increase its production capacity, preferably with the help of private investments. That of course can only happen in an environment where the rule of law applies, and where private investors, foreign and local, are welcomed. The private sector, and not the state, is the only guarantor of long term economic success.

Mexico should re-direct its industrial policy toward energy intensive activities. Mexico has an abundant supply of labor and needs to improve its supply of energy. Unfortunately, the political view of the energy reform continues to favour a rentist mentality instead of one focused on competitive investments. Mexico should aim at becoming North America's new Detroit , in addition to becoming NAFTA's refining and petrochemical powerhouse. Like Venezuela , the success of that strategy relies on an economic model based on market competition and private enterprise.

In short, high oil prices are here to stay, but that is not the end of globalization. However, it could offer a strategic advantage to Mexico and Venezuela if both countries are able to capture the opportunity. Will they?

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